Reform in China a Long-Term Drag on Growth

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Matt MillerAndrew H. Dougherty

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Matt Miller: China, to some extent, has been hailed by observers for trying to mitigate the worst aspects of the global financial crisis, basically, by throwing a lot of investment spaghetti against the wall —

Andrew Dougherty: Right.

Matt Miller: — a big chunk of which may have been doomed to be empty buildings in second-tier cities that there’s not demand for yet. On the one hand, awful — that means there’s going to be a period of adjustment, if not bankruptcy. But it also meant that the bottom didn’t fall out after 2008 in the way that it did in some other economies.

Andrew Dougherty: This contradiction that you’re referring to is somewhat comical, you know. Policy advisors — external international policy advisors — would say you need to take the pain now, do all of these reforms so that you have a more sustainable growth path going forward. And then, a week later, when markets are shuddering, the policy advisors — our counterparts on the other side — are saying, “Hey, can you make sure things are stable?”

So I think the Chinese are hearing multiple messages that are somewhat contradictory. And frankly, they’re debating in trying to square that circle themselves, domestically. They’re very disciplined and vigilant about studying other markets and other economies and how certain policy decisions have impacted the evolution of those economies — and in particular, Japan. I mean, they’ve studied the Soviet Union from a political evolution [standpoint]. They’ve studied Japan’s last two or three decades from an economic standpoint. They’ve seen that kind of long, slow grind, and they don’t want that. And so they want to do structural reform — supply-side reforms that really help pave a sustainable growth path. The problem is, politically, those things are always difficult. Doesn’t matter what country you're in and political system you have. It’s very difficult to do things that, near term, are bad for growth.

Matt Miller: What are some examples of what supply-side reforms would be, and what are the near-term costs of that, that make them hard?

Andrew Dougherty: Supply-side reform in the Chinese context, at least at the moment, is really focusing on reducing overcapacity in certain heavy-industry sectors. At the moment, coal and steel are the primary targets for those capacity reductions. But it applies to aluminum and cement and shipbuilding, and there’s a long list of sectors that have way too much capacity, which really is a function — as you suggested earlier — of this credit boom in 2009, ’10, and ’11 that stimulated, frankly, the investment side of the economy.

Those were great sectors to be in from a profitability standpoint during those years, but now there’s just not demand for it. So the regulators and the policymakers know that they have to reduce capacity, know that these are drags on the banking system, know that it’s creating nonperforming loans. But again, this is a difficult process. So what does it mean in practice?

Well, it probably means private companies — smaller private companies in those sectors — going bankrupt or being purchased by state-owned companies. And it probably means smaller state-owned companies being absorbed by seeing M&A in those sectors among state-owned enterprises. So it’s really about large companies taking on, to some extent, the burden of the smaller companies. Some people are being let go. They’re trying to do it in a way where capacity is being reduced but you’re not having a huge unemployment problem on a regional basis. They’re sort of managing it depending on the demographic of the labor force, depending on the region. But this is a very difficult process politically, even in China.

One example is a small mine — about 10 million tons of coal capacity — owned by a state-owned coal company in Beijing. A large company. And this little town of 10,000 or so people is economically very dependent on this coal mine. Well, this SOE [state-owned enterprise] in Beijing wanted to close this mine as part of this capacity closure, and the local government officials didn’t want that to happen — and so it hasn’t happened. Now this doesn’t make sense to us. Why can’t an authoritarian government — very powerful, centrally owned, state-owned company — be able to close a small asset of theirs in a small town. It’s just the complexity of local vs. central government relations and how powerful local government officials are.

So, that’s a long way of saying it’s a very complicated process. Supply-side reform will take multiple years; this is not a one-year thing. And so this will be a drag on growth in GDP for the next several years.

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